What is Free Cash Flow to Equity?
Free Cash Flow to Equity (FCFE) represents the cash available to a company’s shareholders or investors. These are the cash flows that come after deducting all the expenses, reinvestment, and debt expenses from a company’s total cash inflows. FCFE is a crucial metric for investors as it allows them to understand how much income they can get from their investments.
Free cash flow to equity shows the cash that companies generate and are available for distribution to shareholders. However, that does not imply that the company must distribute it. There are some factors that may affect how much shareholders can receive. Despite that, FCFE allows shareholders to develop expectations. Similarly, it provides them with a comparison tool to use for various investments.
How does Free Cash Flow to Equity work?
The FCFE is a metric that investors use to measure a company’s value. Usually, investors can use the FCFE as an alternative method to evaluate a company that does not pay dividends. It is also better to use the FCFE for companies that have a stable capital structure. Sometimes, the FCFE calculation may also result in a negative amount.
Investors usually prefer investing in companies with a positive or growing FCFE. It is because a negative FCFE can be an indicator of underperforming stocks. However, some stable companies may also have a negative FCFE due to large capital investments or debt repayments.
How to calculate Free Cash Flow to Equity?
The formula for Free Cash Flow to Equity is similar to that of free cash flow. However, it also considers the net debt issued by a company, which the original does not. Therefore, investors can use the formula below to calculate FCFE.
Free Cash Flow to Equity = Cash from Operations – Capital Expenditure + Net Debt Issued
All of the information required to calculate a company’s FCFE is available on its Cash Flow Statement. Sometimes, however, the information for the above formula may not be available. Therefore, investors may also use another formula to calculate FCFE, as below.
Free Cash Flow to Equity = Net Income + Non-Cash Expenses ± Changes in Working Capital – Capital Expenditure + Net Debt Issued
The above formula expands on the original one in calculating FCFE. The net income and non-cash expenses part of this formula are available in a company’s Income Statement. The changes in working capital represent the differences between a company’s opening and closing working capital balances. These include inventory, account payable, and account receivable balances. These are all available on the Balance Sheet.
Example
A company, Red Co., has a total net income of $500,000. The non-cash expenses, including depreciation and amortization, for Red Co., amount to $50,000. The net changes in working capital from the balance sheet were -$100,000. The company also incurred a capital expenditure of $150,000 during the period. Lastly, Red Co. also had net debt issued of $75,000.
Therefore, Red Co.’s free cash flow to equity will be as below.
Free Cash Flow to Equity = Net Income + Non-Cash Expenses ± Changes in Working Capital – Capital Expenditure + Net Debt Issued
Free Cash Flow to Equity = $500,000 + $50,000 – $100,000 – $150,000 + $75,000
Free Cash Flow to Equity = $375,000
Conclusion
Free cash flow to equity represents the cash available to a company’s investors. It is after deducting all expenses, reinvestment, and debt repayments from its cash inflows. FCFE is crucial for investors that want to measure a company’s value. The calculation of FCFE is straightforward and similar to the FCF.
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